eBay-nomics

Modern economists have assumed that people in auctions behave rationally. Then came eBay.

By Christopher Shea | June 10, 2007

In Rome, they called it calor licitantis, or "bidder's heat." If you got swept up in the passion of an auction and paid way too much for something, you could plead a form of temporary insanity, and the judges might step in and let you off the hook (and get you your money back).

Good luck finding that kind of help the next time you overbid on that used iPod on eBay. You bid for it, you pressed the button, you bought it.

The Romans knew something that modern economists lost sight of at some point: Auctions lead people to do weird things. For a long time, economists have explored and even reveled in the supposed purity of auctions, viewing them as uncannily efficient means of moving goods into the hands of people who value them the most.

In fact, studying auctions has long been a fertile subfield within economics. The late economist William Vickrey won a Nobel in economic science, in part for his work in auctions. A 1961 paper of Vickrey's detailed the elegance of so-called sealed-bid, second-price auctions, in which the winner pays the price submitted by the second-place bidder. (Among other advantages, such auctions reduce the likelihood that a bidder will overpay for an item.) This spring, Harvard's Susan Athey, who helped British Columbia design timber auctions crucial to its economy, won the John Bates Clark Medal, given to the most accomplished economist under 40.

Now, however, economists and other social scientists are as likely to be interested in the quirks and inefficiencies of auctions -- and the irrationality of bidders -- as in their elegance. And since eBay, the hugely successful online auction site, offers a mountain of data about sellers and bidders every day, its glazed-eyed devotees are the guinea pigs for this new wave of research.

The new work -- call it "eBay studies" -- highlights the degree to which human psychological quirks, and not just supply and demand, drive auctions. Studies of eBay might ultimately help economists ensure that high-stakes auctions, like those through which the US government distributes the electromagnetic spectrum, are as efficient and fair as possible. But understanding eBay, with its $6 billion in revenues last year, is itself no small matter.

The idea that psychological factors affect economic moves is by now widely accepted, but most economists view those quirks as background noise in markets that are still largely rational, says Ulrike Malmendier, an economist at UC-Berkeley who has studied eBay. "The big theme of my research," she says, "has been how market forces can actually exacerbate biases" -- for example, the tendency to be swayed by peer pressure.

A working paper, titled "Bidder's Curse," that Malmendier co-wrote, offers a clear-cut case of eBay-bidder irrationality. Malmendier and Lee examined hundreds of auctions on eBay involving aboard game, "CashFlow 101," which (nice touch) is supposed to teach people about sound business strategy. At the time the authors collected their data, you could buy the game through official channels for about $195.

During eight months in 2004, the two economists found several hundred eBay auctions involving the game, typically with a starting price of around $45. eBay sellers, however, also offered the game for a take-it-or-leave-it price, typically $125. On eBay this is called the "Buy It Now" option.

As the economists tracked the bidding, they were astonished to find that more than 40 percent of the time the auctions produced prices higher than those available a click away, from other sellers, through the "Buy It Now" option. Caught up in the moment, bidders evidently forgot they could get the game cheaper, instantly,

A new book by Princeton computer scientist Ken Steiglitz, "Snipers, Shills, and Sharks: eBay and Human Behavior," serves as a primer on auction theory and also surveys the latest eBay research. He explains that eBay auctions are variants of Vickrey auctions: Winners pay the price offered by the second-place bidder (plus a small surcharge). Yet eBay auctions usually last a week, leading to the kind of bidder's heat more typical of so-called English auctions (in which a barker shouts, "Do I hear $150?").

Steiglitz and others document the tricks sellers use to ignite bidding wars. Classical auction theory, for example, suggests that sellers should never set an opening price below the value they themselves place on an item. But in a working paper called "When Rational Sellers Face Non-Rational Buyers," Uri Simonsohn, an assistant professor at the Wharton School, and Dan Ariely, a professor at MIT's Sloan School of Management, find that eBay sellers do precisely that: They set low opening prices to provoke the herd.

Peddlers of DVDs who start the bidding at one dollar, Simonsohn and Ariely found, usually attract bargain-seeking bidders And it turns out that, given two identical DVDs, many eBayers will (illogically) prefer the one with more bidders. A DVD that started at $1 but is now priced at $8, Simonsohn and Ariely found, had a 91 percent chance of attracting another bid. But when the opening price for a similar DVD was $8, that auction had only a 76 percent chance of attracting even one offer.

As not all bidders act irrationally, this strategy turns out the be a wash for sellers who deploy it, because they end up selling a few DVDs for below-market prices. But bidders who act like cattle are consistently hurt.

The data show that experienced eBayers avoid crowded auctions. They also "snipe," bidding at the very last second, so they don't tip their hand as to what they think an item is worth. (The more sniping there is, the more eBay turns into a pure Vickrey auction.)

Irrationality also rules when it comes to shipping costs. Economic theory suggests that rational bidders would add the cost of a product to the shipping fee when they ponder whether to bid on an item. In fact, John Morgan, of Berkeley's Haas School of Business, and Tanjim Hossain, of the Hong Kong University of Science and Technology, have found that a significant minority of eBay bidders basically ignore shipping costs. Sellers can therefore pad their pockets by charging, say, $4 to mail a CD.

Hidden costs occur in all sorts of retail markets, Morgan points out. But "it was an open question how many sheep are out there -- and how profitable this practice is," he says. "I think the real contribution of this eBay stuff is to give some answers to the, 'How much?' question." By one estimate, 45 percent of bidders neglect to consider shipping costs.

All of this may make eBay's patrons sound ridiculous. And, indeed, some auctions do serve as efficient fool-identifying machines. Still, auctions remain important and elegant economic engines, and the new research, although it's at an early stage, may ultimately help fine-tune them.

Princeton's Ken Steiglitz, for one, is a happy eBay customer, sniping away late into the night, hunting down the ancient coins he has long collected. Quirks aside, he says, eBay is "a beautifully tuned piece of machinery."